Legendary investors such as Warren Buffett, the chairperson of Berkshire Hathaway, and Peter Lynch, the former fund manager of Fidelity Magellan Fund and current chairperson of Lynch Foundation, are proponents of value investing.
What exactly is value investing? How does it work? What are the investment goals and objectives of value investors? How does it differ from other investment strategies such as growth investing? This article list and explains the core principles of value investing.
7 Core Principles of Value Investing
Value investing draws inspiration from the works of economists and investors Benjamin Graham and David Dodd in the 1920s and 1930s. It is currently defined as an investment paradigm and one of the most popular investment strategies that involve buying securities such as stocks that appear to be undervalued or underpriced based on fundamental analysis.
Buffett simply defines value investing as an investment activity that involves buying stocks at less than their intrinsic value. This strategy is also applied in the more specific dollar-cost averaging approach to investing. To understand further what this investment strategy is and what value investors do, take note of the following principles of value investing:
1. Different From Speculation
Value investing is different from speculation. Graham, in his book “The Intelligent Advisor,” explains that thorough analyses equip investors with informed investment decisions. Value investing involves looking at the fundamentals of prospective companies. However, investment decisions that do not go through analyses are speculative.
Investors who adhere to value investing are not buying stocks in hopes that the issuing companies would make it big in the future. They are essentially buying stocks that appear undervalued and at a considerable discount to their true value today. Gains come from market corrections or when these stocks attain proper market valuation.
2. Dependent on Intrinsic Value
Note that value stocks appear undervalued due to different factors. Some examples include massive sell-off transpiring across the stock market, misfortunes affecting the issuing companies or the industries or sectors in which they operate, or failure of investors and traders to recognize the upcoming growth potential of the involved companies.
Value stocks appear to be undervalued based on their current trading prices and some forms of fundamental analysis. However, when considering other factors such as the dividend streams, discounted cash flows, and the residual income of the issuing companies, the intrinsic value of these stocks is higher than their current valued price.
The intrinsic value of a particular stock fundamentally represents its true value determined based on the monetary benefit that one would expect to receive from it in the future. The true value of this stock is derived independently from extraneous factors. Value investors pick value stocks after performing the needed analyses to determine their intrinsic value.
3. Requires Thorough Analysis
Proponents of value investing have emphasized the need to thoroughly research prospective companies to determine if they are issuing undervalued stocks that have the potential to appreciate after a market correction. Remember that value investing is not speculation because it focuses on the intrinsic value of undervalued stocks.
Researching a particularly involves being passionate about the ins and outs of its business. Value investors dig deeper into its financial statement and other pertinent reports to have a complete understanding of its financial standing and its current and future directions. Doing so requires understanding what the numbers mean.
4. Necessitates Time and Patience
There are instances in which companies take time to see the prices of their stocks appreciating. Note that this is the reality of investing in the stock market. Most value stocks also take time for their prices to match their respective intrinsic value. These securities are suitable for investors who want to remain invested in the long term.
In addition, because of the time it needs for value investors to reap the benefits of their investments, their investment goals and objectives have longer timeframes that range between 5 years and10 years or more. Examples of these targets include retirement plans for adults in their 20s to 40s or the education fund for children between the ages of 0 to 10.
Some small-cap stocks can be value stocks. Other mid-cap stocks and large-cap stocks can be value stocks as well. Only time can indeed tell if investing in these stocks is a worthwhile pursuit. However, it is also important to reiterate the fact that with thorough and constant research, picking the right value stocks is possible.
5. Contrarian Investment Perspective
Another key principle of value investing is a contrarian perspective. Note that herd behavior is rampant in both long-term investing and trading. Some passive investors often offload their stocks during market downturns and several active investors and traders place a sell order during anticipated or existing slumps.
What set value investors apart from other investors is that they remain true to the principles of buy-and-hold investing and the invest-and-forget investment notion. The prices of some stocks decline during massive selloffs. Value investors see this situation as an opportunity to look at these stocks in a manner that goes against the ongoing investing herd.
6. Avoiding Losses is a Top Priority
Buffer laid down two rules in value investing: the first is to never lose money and the second is to never the first rule. Some collectively call these rules the safety principle. Graham also adheres to these principles, Nonetheless, these rules mean that an ongoing investment pursuit and the applied strategy is not value investing if it books losses.
Remember that value investing is about picking undervalued stocks that have been analyzed to increase in value in the future. Value investors know that investing in the stock market has risks. They also understand the risk-return tradeoff that states that investments with higher potential returns come with a higher potential risk of losses.
Risks are inevitable but manageable. Value investing is also about minimizing the risks that come with stock investing or maintaining a stock portfolio. The stocks that value investors pick and hold have been subjected to thorough analyses to give an assurance of gains. This means that value investing is about minimizing the risk of big losses.
7. Seeks Adequate Investment Returns
The goal of investing is simple. An investor invests to grow his or her money. However, because investment comes with risks, realizing this simple goal can be challenging. Another one of the principles of value investing is for the value investor to seek an adequate return. Graham defines this as a return that a reasonable investor is willing to accept.
Note that the aforesaid principle also adheres to the principle of making loss avoidance a top priority. However, to spell the difference better, seeking an adequate return means setting how much return a particular investor targets. This can mean beating stock indices or outperforming index funds. The goal of value investing is to maximize potential gains.
Comparison With Growth Investing
Value investing is often compared with growth investing. These two strategies have unique principles and they seem to sit at opposite ends of the spectrum. Value investing focuses on undervalued companies while growth investing focuses on overvalued companies.
Several observers have also noted that value stocks and growth stocks go through bear and bull markets in relation to each other. Hence, in several instances, when value stocks underperform, growth stocks tend to overperform.
Both strategies have risks. Some consider value stocks as riskier investments than growth stocks because of value traps and the cons of high-yield stocks. Others argue that growth stocks can be riskier if these stocks also happen to be small-cap stocks.
Each can bring forth either substantial gains or considerable losses. Nevertheless, adopting and implementing either of these two investment strategies require conforming to the investment goals and objectives and the risk profile of a particular investor.
